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Edited by Merritt B. Fox & Michael A. Heller

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"This is a terrific collection of papers on an important topic. Fox and Heller's piece does a wonderful job of clarifying the terms of the debate by showing what is good corporate governance and why we care."--Edward B. Rock, University of Pennsylvania Law School

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Corporate Governance Lessons from Transition Economy Reforms

Princeton University Press

Chapter One

Merritt B. Fox and Michael A. Heller

This book draws on a rich array of deviant corporate behavior from economies in transition to craft lessons for corporate governance theory. The very first lesson from transition is that standard corporate law theory needs a better definition of good corporate governance. Theorists have long used the term freely, but rarely explained just what they mean. We define corporate governance by looking to the economic functions of the firm. On the basis of this definition, we develop a typology that comprehensively shows all the channels through which bad corporate governance can inflict damage on a country's real economy. Many of these channels are far more visible when approached from the transition angle, but they are present in rich economies, just harder to spot. This definition helps unify such seemingly diverse experiences as Miwa and Ramseyer's nineteenth-century Japanese case in chapter 6 and Coffee's modern Czech example in chapter 7.

In developing our definition, we use the Russian experience in the first post-Soviet decade for our primary case, in part because it exhibits such a rich array of deviant corporate behavior. Overall, Russian industry performed poorly after privatization. The voluminous literature on transition economies explains this poor performance primarily in terms of continued bureaucratic meddling, poor macroeconomic and tax policy, and low human capital; problems in corporate governance often are mentioned as well but little analyzed. After the fall of Russian communism, state enterprises were privatized rapidly, stock markets created, and a corporate legal code adopted. However, even at its peak, before the 1998 collapse, the total stock market capitalization of Russia's two hundred largest companies only reached about $130 billion-less than that of Intel Corporation. In early 1999 the numbers were "phenomenally abysmal; if they could sink any further, shares would literally have a value of zero. As it is, the entire market is made up of penny stocks." These numbers represent a trivial fraction of the apparent value of the underlying corporate assets controlled by Russian corporations. The low prices reflect severe corporate governance problems, including the high probability that the firms' underlying assets will be mismanaged grossly and that whatever cash flow is produced will be diverted to benefit insiders or reinvested in unproductive projects, as Black, Kraakman, and Tarassova discuss in chapter 4. What were the consequences of these corporate governance problems for the real economy in Russia?

To answer this question, we define corporate governance in a way that looks to the economic functions of the firm rather than to any particular set of national corporate laws. Firms exhibit good corporate governance when they both maximize the firm's residuals-the wealth generated by real operations of the firm-and, in the case of investor-owned firms, distribute the wealth so generated to shareholders in a pro rata fashion. Bad corporate governance is just the failure of a firm to meet one or both of these conditions. Whether managers operate their firms in ways that meet these conditions depends on the structure of constraints and incentives in which they operate, a structure that depends in part, but only in part, on the prevailing legal system-a point that Rapaczynski develops further in chapter 5. In this chapter, we give more precision to the idea of "bad" corporate governance by developing a novel typology of the kinds of damage to the real economy that loosely constrained and poorly incentivized managers can inflict. By canvassing a rich array of deviant behavior, we identify why this damage has been particularly severe in Russia.

Our analysis is not confined to the Russian experience alone; rather, it provokes rethinking of corporate governance theory more generally. For the first time and in a comprehensive way, we link poor corporate governance to real economy effects. We create an analytic tool that identifies the complete set of vulnerabilities to corporate governance problems that may arise in any economy and that helps to generate more tailored policy responses than previously possible. To skip ahead, the chapter works toward table 1.1, which summarizes the complete framework of corporate governance pathologies. We will arrive there by defining what counts as good corporate governance, and then by drilling down to each of the ways that governance can go wrong.

A Typology of Corporate Governance Failures

A. A Simple Definition

Commentators on transition economies invariably discuss the consequences of "poor corporate governance" but without specifying what that means. What little commentary does exist tends to focus on some idealized set of corporate law rules. In contrast, we measure the quality of corporate governance in terms of the social welfare impact of firm decision making. We make no prejudgments about which institutional arrangements work best in any particular country. Indeed, Pistor's and Mahoney's work, in chapters 2 and 3, suggests the challenges of such an enterprise. Under our definition, good corporate governance requires two things: (1) managers must maximize their firm's residuals; and (2) firms, at least investor-owned firms, must distribute those residuals on a pro rata basis to shareholders. Let us consider each element in turn.

The first key feature of a well-governed firm is that its managers make decisions that seek to maximize the residuals that the firm generates over time, discounted to present value. Residuals are defined as the difference between what a firm pays at contractually predetermined prices to obtain its inputs and what it receives for its output. We define this criterion in terms of residual maximization rather than share value maximization to avoid foreclosing the possibility that labor- or consumer-owned firms may be optimal in certain situations. In an ordinary investor-owned corporation, however, the residuals go to shareholders who provide the firm's equity-based capital, which is the only input not obtained at contractually predetermined prices. Thus, for such a firm, maximizing share value is equivalent to maximizing residuals. The conclusion that it is socially desirable for a firm to maximize its residuals flows from two assumptions, both of which are standard in simple models of the corporation: (1) that the firm purchases its inputs and sells its outputs in competitive markets, and (2) that there are no important externalities or subsidies. Thus, the contractually predetermined prices the firm pays for its inputs (other than its equity-based capital) are equal to the value of what the firm takes from society; similarly, the firm's selling prices for its output equals the value of what it gives to society. Maximizing the difference in value between inputs and outputs maximizes the firm's contribution to society and hence constitutes efficient behavior. In the case of an ordinary investor-owned firm, the second feature of good governance is that the residuals are distributed to shareholders and in a pro rata fashion. Meeting this second condition is not strictly necessary for one-period, static efficiency. For a single period, all that is necessary is that the residuals be maximized, regardless of who receives them. The pro rata distribution condition is helpful, however, in achieving the efficient allocation of...